2.4 Inflation

• Inflation:

  An increase in the average price level over time, as measured by a weighted basket of goods, expressed as a percentage.
• Deflation:

  A decrease in the average price level measured by a weighted basket of goods, where the inflation rate is below zero.
• Disinflation:

  A reduction in the rate of inflation. The price level will still be rising but at a lower rate.
• Hyperinflation:

  An excessively high rate of inflation. For example, the rate of inflaton in Venezuela 2019 reached 350,000%.
• The policy objective of low and stable inflation:

  This provides price stability which is low enough to not affect the decisions of firms or households significantly, promoting business & consumer confidence.
• Real values:

  Values adjusted for inflation
• Nominal values:

  Values unadjusted for inflation, at current prices.
• Consumer Price Index (CPI):

  This is a measure of the general level of prices in the UK. It excludes housing costs & council tax, therefore the CPIH became the headline figure in 2017.It is constructed using the family expenditure survey which measures changes in prices of approximately 650 goods & services. The data is weigthed to take into account the relative importance of different items of expenditure.
• Retail Price Index (RPI):

  The government still uses this measure of inflation to index the state pension & as a cost escalator for government transfer payments & wage negotiations.
• Demand-pull inflation:

  Increases in the price level (inflation) resulting from an excess of demand over output at the existing price level, caused by an increase in aggregate demand. Illustrated by a shift rightwards of the AD curve. It is more significant when there is a rise in AD at a time of full employment.
• Cost-push inflation:

  Rising prices as a result of rising production costs, illustrated by a shift leftwards of the SRAS.
• Consequences of inflation:

  1. A fall in the purchasing power of money 2. Reduction in the real rate of interest & the return on savings & investments in the future 3. Uncertainty 4. Loss of international competitiveness 5. Fiscal drag -tax brackets are not adjusted in-line with inflation... 6. Shoe-leather costs 7. Menu costs.
• Diagram to illustrate demand-pull inflation

  A) Average price level

  B) SRAS

  C) AD1

  D) AD2

  E) Real Output

  F) Y1

  G) Y2

  H) P1

  I) P2

  
• Diagram to illustrate cost-push inflation

  A) Average price level

  B) AS1

  C) AS2

  D) AD

  E) Real GDP

  F) Y1

  G) Y2

  H) P1

  I) P2